Ambac Financial Group Inc (AMBC) 2006 Q2 法說會逐字稿

Greetings, ladies and gentlemen, and welcome to the Ambac Financial Group Incorporated second-quarter earnings conference call. [OPERATOR INSTRUCTIONS] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Mr. Sean Leonard, Chief Financial Officer of Ambac Financial Group, Inc. Thank you. Mr. Leonard, you may begin.

Thank you, good morning and welcome to Ambac's second-quarter conference call. I'm Sean Leonard, Chief Financial Officer of Ambac. With me today are Robert Eismann, Controller, and Peter Poillon, Investor Relations. This call is also being broadcast on the web. Our earnings press release, quarterly operating supplement, and a short slide presentation that summarized the quarter's results are on our website. Third quarter 2006 earnings will be released on October 25, 2006, at 8:00 a.m. with a conference call at 11:00 a.m.

During this conference call we may make statements that would be regarded as forward-looking statements. These statements are based on management's current expectations. I refer you to our press release for factors that could change actual results. Now for highlights of the second quarter.

Net income was 238.6 million or $2.22 per diluted share. That's up 31% on a per-diluted basis from second quarter of 2005. While Ambac reports net income in accordance with generally accepted accounting principles or GAAP, research analysts make certain adjustments to net income to calculate their reported estimates. Therefore, to enhance investors' understanding of our financial results, we continue to provide information on the items that analysts adjust out of GAAP net income to arrive at their current estimates. Those items are net after-tax gains and losses from sales of investment securities and mark-to-market gains and losses on credit, total return, and nontrading derivative contracts.

In second quarter of 2006, net after-tax gains amounted to 32.9 million or $0.31 per diluted share. This compares to net gains of 14.9 million or $0.14 per diluted share impact in the second quarter of 2005. Some analysts also back out the after-tax effect of accelerated premiums earned on obligations that have been refunded and other accelerated premiums. Total after-tax accelerated premiums amounted to 22.8 million or $0.21 per diluted share in the second quarter of 2006, which compares to 14 million or $0.12 per diluted share in the second quarter of 2005.

Now turning to credit enhancement production or CEP. CEP which represents gross up-front premiums plus the present value of estimated installments on insurance policies and structure credit derivatives issued or assumed in the period came in at 531 million. That's up 33% from 397.9 million in the comparable prior period. This quarter's business production is the highest in the Company's history. Our recent, high production quarters have been characterized by the closing of large premium transactions. Historically this has been the case in the international sector, but is becoming more prevalent in structured finance and to a lesser extent public finance. These large transactions tend to be high value-added deals, and therefore are highly profitable and a good use of our capital, serving to offset otherwise difficult market conditions.

Now let me take you through some of the details of our production by segment. Public financed CEP was 132.1 million, that's down 22% from the second quarter of 2005. So overall market issuance was down slightly. However, the biggest driver in the reduced writings was again the mix of business that came to market in the quarter, and that targets the highly structured segment of the muni market and that segment of the market was slow during the quarter. Overall municipal market issuances reported by third-party sources was down about 3% from 111 billion in second quarter of 2005 to approximately 108 billion in the second quarter of 2006. While insured penetration declined from about 61% in second quarter of 2005 to 45% this quarter. Year to date 2006 market penetration is approximately 48%. A level that is more in line with historical trends.

Ambac's market share in the quarter based on par written was approximately 22%, down from about 27% in the second quarter of 2005. Generally we find the municipal market to be the segment of our business that is seeing the most price competition from other mono lines in 2006. Structured finance CEP was a record 212.8 million, up 50% from the second quarter of 2005. Payback closed deals across a wide array of sectors with commercial asset back to pool debt obligations and structured insurance providing the strongest growth. In the NBS market, spreads remained quite challenging. International CEP in the second quarter came in at 186.1 million, also a record for Ambac. It was up 116% from the second quarter 2005.

As reported in our first-quarter conference call, we closed some large and attractive UK private finance initiative transactions back in April. However, our second quarter international production was again quite diversified in terms of geography and asset class. Deals closed in this segment included transactions in seven different countries outside the US, and in such asset classes as investor-owned utilities, feature flow transactions, and CDO's. In addition to the PFI deals mentioned earlier. Ambac remains very optimistic about our long-term opportunities in the international markets.

Now turning to premiums earned. Net premiums and other credit enhancement fees earned, excluding refunds increased to 187.6 million, that's up 3% from the second quarter of 2005. Public finance earned premium excluding accelererations grew 6%. Public finance earnings have been impacted by the level of refundings in the book over the past two years and by the mix of business written over the past several quarters. Structured finance grew 9%. Excellent recent production in asset classes such as commercial ABS, auto securitizations and TDO's has offset the negative growth trends caused by lower MBS writings and a high prepayment activity in this segment. International earned premiums declined by 6%, due primarily to lower, new business production over the past several quarter prior to this one. An increase in the weighted average life of business originated in recent years and early run-off and early term nations in the international book of business.

During the past six quarters we have written about 17 billion of net par and in international, but the total international book actually declined by more than 15 billion over that period. Our deferred earnings representing future earnings on premiums already collected and the future value of installments increased to 5.9 billion, that's up more than 6% from the beginning of the year. These deferred earnings will be recognized as earned premium and other credit enhancement fees in the future over the life of the related exposures.

Turning to investment income, investment income excluding VIE income was 104.5 million, up 13%, primarily due to growth in the portfolio driven by strong operating cash flow, including cash received related to the reinsurance buyback and sale of aircraft. And the 200 million capital contribution from the parents in the fourth quarter of 2005. Rising interest rates have also had a moderate, positive impact on our investment portfolio.

Loss provisioning amounted to 12.8 million, down from 21.7 million in the second quarter of 2005. Total net loss reserves at June 30, 2006, amounted to 285.7 million, down from 293 million at March 31, 2006. Total loss reserves include case basis reserves of 138.7 million, inactive credit reserves or ACR, up 147 million. Case reserves activity resulted in a net increase of 17.4 million, driven by additional reserves for health care transaction and a loss expense reserve. During the quarter we paid claims amounting to 20.1 million, which included a payment for a CDO transaction that had been classified within our ACR. Transferred to Case and paid within the quarter as the transaction terminated. ACR decreased by 24.7 million driven by net positive migration within our classified portfolio and the aforementioned transfer from ACR to Case.

With regard to our Hurricane Katrina reserve estimate, it currently stands at 90 million. Down slightly from the original 92 million. Many of you are aware that the State of Louisiana recently issued 400 million of Gulf bonds backed by the full faith and credit of the state. Funds from that bond issuance will go to certain issuers within New Orleans parish to help pay a portion of debt service on their outstanding bond obligations. This liquidity injection is a positive development that will be evaluated as the funds get distributed.

We continue to be actively involved in meetings and discussions with the appropriate parties, and as with all stress credits within our portfolio we will continue to be rigorous in our surveillance and remediation efforts. There's nothing new in regard to the FAS, Financial Accounting Standards Board, review of financial guarantee, financial reporting. I remind you that our accounting policies are subject to change in the future.

Our 2005 Form 10-K that was filed with the SEC in March provides a thorough discussion of our loss reserve policy, our loss reserve methodology and potential for future changes. A couple comments on financial services. Financial services net revenues excluding realized and unrealized gains and losses were 10.8 million, compared to 3.3 million in the comparable prior period. Our financial services segment is comprised of the investment agreement business and the derivative products business. Net financial services revenue in second quarter of 2005 included a negative mark-to-market adjustment in the derivative products business resulting from the increase in the ratio of tax-exempt interest rates and taxable interest rates amounting to 6 million. Excluding the mark-to-market losses, financial services net revenues increased as a result of increased spreads in the investment at grade [Inaudible]. One other item to note, that's in our financial services results was at $38 million cash recovery from our 2002, 2003 writeoff of an investment security within our investment agreement portfolio. Our return on equity was a robust $17.2% for the quarter on an operating basis ROE was 15%.

Ambac announced we're increasing our quarterly dividend by 20% from $0.15 to $0.18 per share. Ambac has raised its dividend every year since going public in 1991. During the second quarter, Ambac did not buy back shares. We are comfortable with our capital position, considering recent rating agency model results and our goal of optimizing our capital position consistent with a AAA-rated company while maximizing shareholder value. In summary, Ambac had an excellent quarter, generating excellent financial results and a record level of business production. Ambac's focus on the higher return segment of the markets that we serve has been a key component of our success. And that concludes my prepared remark. I would now like to open it up for questions.

Thank you. [OPERATOR INSTRUCTIONS] Our first question comes from Mark Lane with William Blair and Company. Please state your question.

Good morning. Just three quick ones. First of all, in the case reserve, the increase in the health care claim. Is that the same health care claim?

Yes, Mark. It is.

So where does that reserve now stand relative to the exposure?

That reserve now stands at substantially all the outstanding exposure that we have to that issuer.

Over 90% or?

Yes.

Okay. And the structure finance business, can you quantify the impact of large deals in whatever fashion you think is appropriate, AGP above certain levels or something like that?

Sure. Yes, CEP for large deals over $10 million of CEP in structured finance there were three transactions there, that of the structured finance CEP total production represented about 55% of the total production.

Okay. And then the last question is within the public finance market, can you compare the second quarter versus the first quarter both in terms of spreads on a consistent product mix basis and also the competitive environment, whether it was stable or worsened sequentially.

Yes. The first is sequentially for the quarters, I think the spreads themselves have remained relatively attractive historically. What we've seen, though, is due to the lower insured penetration. We are seeing competition on the pricing. So what's being charged of that spread. So -- we are seeing intense competition in the public finance sector.

But worse than the first quarter?

I wouldn't say worse. I would say on par, on par with the first quarter. I will say, though, that obviously the first quarter had a lesser of a volume impact. This quarter the volumes quarter on quarter from year to year relatively consistent, down slightly. But the insured penetration is down which kind of indicates that the population of deals to the insured due to the various attributes of them perhaps it's the rating or else why -- it is creating some additional competitive pressures.

Okay. Good enough. Thank you.

Thank you.

Our next question comes from Joshua Shanker with Citigroup. Please state your question.

Yes, hello. The first question, what type of deals are you seeing refi on? I'm sure you're surprised as we are that it's still so strong with the rising rate environment.

We saw this quarter generally in a comparison basis from the public finance year-on-year is very -- the numbers were consistent, up slightly this year. The -- what's generating an additional bump is some larger structured finance transactions that were terminated, and we collected a termination fee on those transactions. So I think that's primarily the difference of what you're seeing in the enhanced accelerated earnings line.

And in terms of directionally on pricing, I'm looking at sort of a back of the envelope calculation on up-front gross premiums written to par. And it seems like there's an upswing in terms of pricing for both public finance and for international, trending better. Does that comply with your analysis, as well?

Joshua, I think what's going on there is we're closing a couple of the large transactions. We think has been favorable. On the international side some of the transactions we've been talking about for some time that we've been working on actually closed in the second quarter. Those transactions date back to, in some cases, pricing that is 2004-type pricing which is generally favorable. So -- and I think generally larger transactions that we're closing are more value-added transactions. So you're seeing a little bit of a bump there. And we continue to see -- we had a -- had a good production quarter in health care, we typically would from a public finance perspective would carry higher premium rates to go along with the risk.

So the improved pricing is more related to the one off transaction but not to a general market condition?

I think that's a good good characterization.

Thank you.

Our next question comes from Geoff Dunn with KBW. Please state your question.

Good morning, Sean.

How are you?

Good, thanks. You said there was no incremental development with the FASB issues out there. But if I remember correctly you're kind of leading the industry charge to work with FASB on the reserving side. How close do you think we are from getting an official proposal from FASB, and what direction do you think that's leaning in?

Yes. Just talked to them last week, because I wanted to get an update on where they stood with their project. It looks like they're planning to have some meetings in August. So those would be public meetings tentatively. They haven't firmly scheduled them. They are telling me tha they're revising their timeline for a document for the fourth quarter of this year and perhaps -- and that would go out for exposure with a comment period. And then potentially a final document in the first quarter of -- of next year. Unsure exactly where they're going with it. I know there's certain constituents that I've spoke with seemed to favor a surveillance/adversely classified list approach which is similar to the approach that Ambac employs.

That's what [AFSKI] submitted, correct?

That's correct. So we'll have to see where that goes. Typically until they have their public meetings and we have offered up a lot of support and education in that process because we obviously want to be actively involved. But it's -- they play their cards close to their vest. So we'll have to see what type of discussions they have in August.

Okay. And then on the structured finance side, I was hoping to get a little more color. Specifically, can you get a little bit more specific on the types of deals that were really showing strength on the commercial side of things? Is the structured insurance segment getting deeper than just the normal XXX deals have been out there? And are you seeing any kind of reprieve in the spread environment on the more commoditized consumer ABS?

On the consumer ABS, we are not -- we're seeing a continued difficult market there, as characterized by a decline in net run-off of our net par insured, the MBS. You'll see that in our supplement. So we're still seeing that as being difficult. On the structured finance side, we did close two transactions in the structured insurance space. Largely they are, as you mentioned, a XXX. I'm not aware of anything other than that that's different there. So that's a little bit of color there.

And on the commercial side?

On the commercial side, there's an interesting transaction that we closed this quarter, securitization of intellectual property/franchise revenues. So that was a very -- very interesting transaction for us.

But no necessary trends within commercial?

No. We are seeing -- obviously they're specialized classes that Ambac likes to target and some expertise in. But we'll continue to work those and track down opportunities where we see them.

Okay. Thanks.

You're welcome.

Thank you. Our next question comes from Ken Zerbe with Morgan Stanley. Please state your question.

Great. Thanks. Just in terms of your buybacks, you mentioned that you're comfortable with your capital position now given I guess your new rating agency models or their updated models. How much should we view that your capital position has changed because of the way the rating agencies are calculating your capital position versus the environment, whether it's structured or international is improving so you're going to be using more of your capital for organic growth as opposed to having it left over internally?

Well, I think there's been -- obviously there was some modeling that recently came out -- was an S&P model results that put us in the 1.3 to 1.4 margin of safety category which is historically where Ambac has been towards the upper end of that range. So I would say that certain things in the capital modeling, S&P being the primary constraint for us at this particular time such as Hurricane Katrina and some other credit events that happened in 2005 obviously had an impact on the results. I would say also that it's a static model that looks at growth rates that are -- that pretty substantial growth rates to grow the business. And obviously that has an impact, as well on the underlying MOS.

So I guess rating agency models aside, do you see more opportunity in terms of organic growth going forward than you did, say, six months ago?

Don't know if I would characterize it necessarily that way. I mean, obviously our earnings are growing, and that has an element of organic growth. We are seeing some run-off in our portfolio. So we'll have to see what develops. That's a part of it. Obviously, the earnings that we get on the portfolio, earnings on the investment portfolio, underlying credit concerns if they happen to go away, or get better. And upgraded will obviously have an impact, as well. I think that's why the capital modeling is such a dynamic approach and it's one that will continually look at it and make determinations based upon where we see the current environment plus where we see it projecting.

Yes. Okay. And just in terms of the refunding, obviously, very strong quarter for that. I know -- I think you mentioned you have $9 million related to structured finance and international deals. But was there anything in the refunding number I guess backing those items out that would lead to it just being such a strong quarter? Because industrywide refundings are still down, 50% this year.

There's nothing that I noticed. You're right. Industrywide refundings are down, and we pretty much stayed constant, a little bit up from public finance in the prior year. Nothing I can particularly -- that's what makes that so difficult to try to project. It's based upon facts and circumstances at individual issuers, depending on when the issuer is actually issued, various contractual terms, and the debt itself. So it's kind of hard -- I didn't see any particular trend there.

Okay. All right. Great. Thank you very much.

Thanks.

Our next question comes from Darin Arita with Deutsche Bank. Please state your question.

Hi, good morning.

Good morning.

A couple of questions here. I guess first thinking about your pipeline of deals in the international and structured finance side, it seems like this quarter there are several large transactions that came through. Does that mean that for the next few quarters it could be pretty quiet here?

No, I think, Darin, we continue to work on some transactions internally, but they're not totally closed out, those transactions in the second quarter. So we continue to work on transactions, larger premium-type transactions. So that is something that is difficult to predict when they're actually going to close. It could be a variety of factors involved there. But we still have some transactions that we're working on.

Okay. And secondly, there's a comment about the change in the credit quality of municipal deals and that led to fewer insurable transactions. Can you talk about that a little more and whether that's some sort of trend.

I don't know about a trend. The reason for the comment was to explain the insured penetration numbers that were getting back more in line with historical trends versus the 61% versus mid 40's. I guess indicating that the insurable population of transactions are going down as a percent of the total. Obviously it's a competitive market out there, and people are looking to do that type of business. So I think it was more to explain that than any trend. We did kind of highlight the fact that that is more in line with historical insured penetration percentages.

Okay, great. Thanks you very much.

You're welcome.

Thank you. [OPERATOR INSTRUCTIONS] Our next question comes from Rob Ryan with Merrill Lynch. Please state your question.

Good morning. What color can you give us on the operating expense level in the second quarter especially in the context of strong refunding activity which must have added to DAC amortization?

Yes. Probably two comments there that you'll see when you look into details in the supplement. One is the increase in compensation costs. As you remember, may remember from the prior quarter, what we're doing there is we're accruing for compensation costs relating to our expected 2007 grants for retirement-eligible employees. So that has an impact of about 1.8 million on a gross basis. And also as part of refundings, we go back and look at DAC percentages for the years that those transactions were originated and we would accelerate DAC to be commensurate with that. So you do see some acceleration of DAC due to the higher refundings.

Can you review for us the expectation of seasonality for this? Why the big sequential decrease again from the first quarter number, and whether we should expect that in '07, as this seasonal pattern, as well.

The seasonal pattern on expenses? With what's happening in -- from the last two years is when for 2005 and 2006 during the first quarter typically in January when we issue our grants to employees, they would -- for retirement-eligible folks we immediately expense those items. What we decided to do with the implementation of the new accounting standard FAS 123R is to record that amount for the anticipated 2007 in 2006. So in a sense you have -- you had double the expense in 2006. So in 2007 we should not see as big a jump, obviously in that line because we will have already expensed that grant.

Okay. In terms of a run rate maybe for the third quarter of '06, if you brought down your DAC amortization to a more normal level based on lower refunding activity in the third quarter compared to the second quarter, does that get us to a good operating expense number for the third quarter? Or are there other considerations?

Thinking. On the compensation side, that should be a pretty good run rate because we don't have the one-time items in the first quarter, 2006. Looking at the second quarter of 2006 should be a reasonable run rate. There is obviously potential to put on additional people, but I think there is -- that would be a reasonable run rate there. Don't know if I have any comments on the DAC. I would have to take a look at that.

Great. Thank you.

You're welcome.

Our next question comes from Matthew Roswell with Stifel Nicolaus. Please state your question.

Yes. Congratulations on a good quarter. First, one very specific question. With the lowering in the discount rate of the CEP to 5.6 in the quarter compared to 7%, how much does that boost the year-over-year growth rate?

The difference between using a 7% rate versus the 5.6% rate is approximately $25 million.

Okay. Thank you. And then a bigger picture question. As we're seeing more and more large deals as well as more structured and international deals, how should we think about the relationship between CEP and the net earned premium, in other words, how -- does it change how we would anticipate those deals to flow through the income statement going forward?

Yes. It depends on the actual tenor obviously of the structured financed transactions. That's kind of the reason for one of the operating supplement schedules that we provide. Is we take the anticipated installment premiums and schedule those out so you will actually see scheduling out of the premiums based upon the transactions in house as of June 30 for the second -- tail end of this year, six months, and then looking into forward years. So it's all kind of blended in there. But generally large transactions that are structured finance that have a shorter tenor will obviously produce quicker earnings.

I guess sort of another way of asking that question, the fact that you're signing larger deals up-front, does that improve the visibility of the future earnings flow, because you've sort of blocked it in with the larger deal relative to kind of historical muni business I guess?

Well, it all depends on the underlying attributes on the transaction. Obviously an up-front deal, you know your premium with certainty. Structured finance transaction if there is the ability to either prepay, refinance, or terminate, that could have an impact on the ultimate collection of the installment premiums. So it would be based upon obviously mortgage-backed securities to take an example would be subject in most cases to prepayment speeds. Obviously that would have an impact as we're charging basis points off an unpaid principle balance. Will have an impact of potentially changing the gross installment premiums collected over the term of that transaction. Opposed to a transaction that perhaps does not have those types of either call rights or prepayment rights. That will be obviously a much more steady premium stream.

Okay. Thank you very much.

You're welcome.

Our next question comes from Gary Ransom from Fox-Pitt, Kelton. Please state your question.

I had a question on the credit cycle broadly. Are there any areas where the credit spreads are so narrow that even if you were able to price so that you got all the credit spread it still didn't compensate you for the risk that you perceive in the market? Are there places or sectors like that?

I don't believe there's sectors like that in the public finance because of the reasonableness of spreads vis-a-vis historical amounts. So the competition is the relation of error, not necessarily the spread. I think there's certain situations in the mortgage-backed sector. Don't know about 100%. But I know there's certain sectors vis-a-vis the structured -- the senior subordinated competition that would be difficult for us to reach our hurdle rates. So I don't know about whether or not we can go up to 100% of the spread and still hit our hurdle rates. That would be something I'd need to look into.

Just as a followup on the mortgage market particularly with the -- a lot of the news about at least some signs of potential problems in consumer credit, how is that showing up, if at all, in your portfolio?

I don't think it has shown up in our portfolio as of June 30. Or as of today as we speak. There hasn't been a large increase in what we're scheduling out as below investment grade or including as part of our adversely classified list.

Okay. Thank you very much.

You're welcome.

Our next question comes from Howard Shapiro from KBW Asset Management. Please state your question.

Actually, my question's been asked. Thank you.

Thank you. There are no further questions at this time. I'll now turn the conference back over to your host to conclude.

Thank you very much. Thank you for attending our call. We will be available to answer any questions that you have, and thanks again. Good-bye.

Thank you. This concludes today's conference. Thank you all for your participation. All parties may disconnect now.